Futures trading is the trading of futures contracts which allows specific stocks, commoditites or such assets to be traded at a pre-determined price in future. For instance, a farmer may short a futures contract on his 5000 bushels of corn grains at the price of $0.30 per bushel to a buyer of corn grains. By doing so, the farmer has guaranteed himself the price of $0.30 per bushel for his corns when harvest time comes. The buyer would also have guaranteed himself the purchase price of $0.30 per bushel. In this case, the farmer is clearly hedging against a drop in price of corns while the buyer is clearly expecting the price of corn to be higher than $0.30 when harvest time comes and commits himself to buying at that price. Of course, this is merely an over simplified example of how futures work.
There are many people who also lump Futures trading and options trading into one term known as Futures Options or Options Futures or Futures Option Trading and take it to mean the same thing. It must be clarified here that Futures, Options and Futures Options are three distinctly different forms of financial instruments and cannot be referred to as one single study.
The above example outlined a classic use of futures in commodities trading, also known as commodities futures trading. Indeed, Futures are derivatives instruments that derive their value from their underlying assets and their main function is to help buyers and sellers of the underlying asset go into purchase agreements that protect against price fluctuations. To date, this remains the most important function of futures trading.
However, apart from being a great hedging tool like it is meant to be, futures trading also opened the door to leveraged speculation of price fluctuations and have created many a lucky stock market millionaire. In fact, with the creation of Single Stock Futures (SSF) in 2002 in the US market by the CBOE, futures trading now extends to stocks of listed companies as the underlying asset, providing participants in the capital market with another avenue of leveraged trading.
Yes, leverage is another reason that makes futures trading so powerful and dangerous.
Futures trading has leverage due to the fact that only a small deposit, known as the initial margin, is needed to control a large amount of underlying asset. Using our corn farmer example above, the buyer of the futures contract on his corns only need pay the farmer a small deposit of maybe only $150 to guarantee the purchase of 5000 bushels of corn at $0.30 per bushel worth $1500 (the "Futures Price") in all. So, instead of paying $1500 to control the price on 5000 bushels of corn at $0.30, the futures buyer paid only $150 to do the same thing. Thats a 10 times leverage on his money.
If the price of corn in this example should suddenly surge to $1 per bushel due to a poor harvest, the buyer of the futures contract would still be able to buy the corn from the farmer for only $0.30 per bushel, and sell those corn in the market for $1.00 per bushel, making a total of $3500 out of a $150 capital commitment. Yes, a 2300% profit! That's the leverage power of futures trading.
4 Main Types of Futures Traders
There are 4 main types of futures traders in the futures market, creating the liquid futures trading environment that we see today. No matter what you choose to do in futures trading, you will inevitably fall in one or more of these types. The 4 types of futures traders are really classified based on the purpose of their trades rather than the actual trading strategies itself as the same futures strategy can be applied for various purposes. The 4 types of futures traders in the futures trading market are; Hedgers, Speculators, Arbitrageurs and Spreaders.
Hedgers do with futures contracts what futures contracts were initially designed to do when it was first developed along the rivers of Chicago (read the History of Futures Trading), which is to hedge against price risk. You are a hedger when you are go short on futures contracts while owning the underlying asset or other futures contracts of the same or related underlying in order to protect your existing positions against price fluctuations.
Speculators form the backbone of the futures trading market we see today. They provide liquidity and activity in the futures trading market through their day trading or swing trading strategies, buying and selling futures contracts outright in order to speculate on a strong directional move. This is also the most dangerous way of trading futures as the price of the underlying asset could just as easily come around and put your position in a loss deep enough for a margin call.
Arbitrageurs are futures traders that are in the market in order to spot price anormalies between futures contracts and their underlying assets in order to reap a risk free return. Arbitrage is another huge source of volume and liquidity in the market as it typically takes an extremely big fund and big trading volume in order to return a worthwhile profit in arbitrage. Arbitrage is such a competitive area right now that super computers with powerful programs to spot such opportunities are set to perform such arbitrage automatically.
Spreaders are futures traders that specialises in trading futures contracts in combination with other futures contracts or underlying in order to reduce risk and to extend profitability. Such complex futures positions are what is known as "Futures Spreads" or "Futures Strategies". This is a very professional and specialised field that has only recently been made known to the general public and makes use of the difference in price and rate of change in price of different offsetting futures contracts in order to create futures positions that move within certain limits and have a much higher chance of profit with a lot lower commissions. Read all about Futures Spreads.
Danger of Futures Trading
Futures traders who buy futures contracts purely for leveraged speculation frequently lose more money than what they put in when prices move against them, triggering margin calls that requires additional top up of money in order to keep the contract alive or be forcefully closed out. Yes, many a multi-million corporations have gone bankrupt due to abuse of futures trading. Too many futures traders have abused the leverage of futures trading by buying futures contracts with almost all their money, expecting prices to go straight up without keeping a reasonable reserve to serve margin calls for those short term price fluctuations. These futures traders frequently lose all their money and more, casting a shadow on futures trading, making futures more dangerous than it really is.
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Futures contracts are standardized, exchange traded and guaranteed, forward commitments to buy or sell a specific quantity of underlying at a specific price and at a specific future date.
Futures Contracts - In layman terms
In layman terms, futures contracts are an agreement between a buyer and a seller to buy a specific underlying asset (commodities such as oil and grain or even currencies and stocks) at a future date and at a price agreed upon now. Futures contracts essentially provide sellers of an asset a guaranteed price for their goods while providing buyers protection against a surge in price.
The term "underlying" in futures trading refers to the asset that a futures contract is written based on. Through futures trading's hundreds of years of development in the US market, futures contracts has been traded for a vast variety of underlyings, including but not limited to; commodities such as grains and oil, currencies, stocks and indexes. Depending on what underlying a futures contract is based on, it will be named accordingly. For example, commodities futures, forex futures, single stock futures and index futures.
Types of Futures Contracts Settlements
A futures contract settlement occurs when the futures contract reach maturity and it is time for the buyers and sellers to fulfill their individual commitments. That is, person holding the long position will buy the underlying from the person holding the short position as agreed in the futures contract. This is known as a "Physical Delivery" settlement. However, futures contracts are not always settled physically with the delivery of the underlying asset. These days, futures trading also take place for more exotic underlyings such as an index which has no physical product to be delivered. As such, futures contracts based on these underlyings are settled in cash rather than the delivery of a physical product. This is known as a "Cash Settlement".
Futures options has confused more beginners to futures trading and options trading than anything. In fact, many futures trading and options trading beginners has come to mistake Futures and Options to be the same thing due to the term "Futures Options". So, what exactly is futures options? Futures options are Options with futures as their underlying asset! Yes, a derivative instrument based on a derivative instrument.
Options give its holder the rights but not the obligation to buy or sell the underlying asset at a specific price by a specific date. In this case, futures options gives its holder the rights but not the obligation to buy or sell the underlying futures contract at a specific price by a specific date. Options are very similar to futures except for the fact that when you buy futures options, you are not subjected to margin calls and you are not obligated to exercise the terms of the option if you do not want to.
There are two main types of futures options; Call Options and Put Options.
Futures Call Options allows you to purchase the underlying futures contracts at a fixed price by a fixed expiration date. Futures call options can be bought in order to speculate on an increase in price of the underlying futures contracts or written in order to hedge against short term price volatility of the futures contracts that you hold.
Futures Put Options allows you to SELL the underlying futures contracts at a fixed price by a fixed expiration date. Futures put options can be bought in order to protect your long futures position from unexpected price declines or written in order to benefit from a price increase in the underlying futures contract.
Who Trades Futures Options
If futures as a derivative instrument is so hard to understand for a beginner to futures trading, then trying to understand a derivative of a derivative would be almost impossible. Yes, Futures Options are derivatives that professional futures traders use in order to hedge the risk in their volatile futures positions. Futures trading can be extremely volatile and sudden, steep, price movements can be disastrous to a trading account even if the position eventually do move in your favor. This is because margin calls need to be fulfilled in order to keep a futures trading position alive and sudden steep price movements against your favor could land your futures trading position in a deep margin call. Inability to fulfill margin call means that you would like miss out on all the profits when the position recovers. This is where futures options comes in handy as a hedging tool. Hedging futures trading positions using options is a complex undertaking that requires strong professional knowledge in both derivative instruments and that is why they are usually used by professional futures traders.
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